Although it is not recommended, it is possible to borrow or withdraw money from one's retirement plans to pay for college. When one does this, all or part of the distribution is taxable. There may also be a 10% early distribution penalty. (The penalty is waived for distributions from an IRA in certain circumstances, but not for a 401(k).) This artificially increases taxable income during the next year, causing the family to qualify for less financial aid.

Many financial aid administrators will use professional judgment to exclude from income the portion of any early distribution that was used to pay for qualified higher education expenses. The reasoning is that there is ample precedent for excluding from income the taxable portion of financial aid awards, such as taxable earnings from Federal Work Study and taxable portions of scholarships and grants. The adjustment is made by including the amount of the early distribution that was used for qualified higher education expenses in Worksheet C. (Although there should be a corresponding adjustment to taxes paid because the change in income reflects a change in taxable income, if the family anticipates making another early distribution during the current tax year, the financial aid administrator should not adjust taxes paid as the taxes and penalties represent a real non-discretionary expenditure.)

Some financial aid administrators will also allow an adjustment for early distributions that result from other financial hardship situations, such as to pay medical bills. (Early distributions from an IRA are not subject to the 10% penalty if the account holder has a qualified disability, the distribution is to be used for qualified higher education expenses, the distribution is to be used for unreimbursed medical expenses above 7.5% of AGI, the distribution is used to pay for medical insurance after having been unemployed for at least 12 consecutive weeks, or the distribution is used to buy or build a home.)

Financial aid administrators can also allow an income adjustment for an early distribution on the grounds that it is not reflective of award year income. (Money in retirement funds not counting as assets is irrelevant to whether distributions are counted or not, since regular distributions, including untaxed portions, are counted as income.)

Parents should be discouraged from taking an early distribution from retirement funds, as it reduces funds for retirement and does not make good financial planning sense. The parents would be better off borrowing a PLUS loan or tapping into a home equity line of credit.